The July rally: Is this a bear market rally or beginning of another stealth bull market?

Ride the bull cautiously

Is this a bear market rally or beginning of another stealth bull market?

Like market corrections, up moves also can be sharp and swift. More often, than not, such moves come unexpectedly. From the lows of 15183 in June Nifty has made a sharp up move of more than 11 percent (as on 21st July). And, this pullback has come when the global economy is facing some strong headwinds.

Where do we go from here?

Markets are interestingly poised. Fears of a likely US recession had led to sharp corrections in markets; but hopes of a lower-than-expected growth slowdown are triggering fresh buying. The heightened volatility in the market indicates that the trend is unclear. The biggest unknown in the market now is that we don’t know how intense the ongoing global growth slowdown would be. It is probable that US might tip into a recession; it is also probable that the Fed might succeed in engineering a soft-landing for the US economy. What should investors do in these uncertain times? 

Undoubtedly, the strongest headwind for the global economy and equity markets is the surging inflation, particularly in the developed markets (DMs). US inflation is at a 41-year high and has been rising steadily: 8.3% in April, 8.6% May and 9.1% in June.  Inflation in UK is 9.4 % in June and in Euro Zone inflation is at 8.6 %. Central banks are tightening monetary policy; bond yields are rising and growth is slowing down. Dollar – the safest asset class during uncertain times – is surging (Dollar index rose above 109) and most currencies are depreciating against the dollar.

Has equity markets discounted a US recession?

US tipping into recession by end 2022 or early 2023 is bad news for the global economy. If the $25 trillion US economy tips into recession, global growth will be impacted. Global trade, too, will be impacted adversely affecting exports from emerging markets (EMs) like India. Equity markets are discounting these concerns. S&P 500 had corrected around 20 percent from the peak. Nifty corrected around 18 percent from the peak. Have the markets discounted a US recession? Partly ,‘yes’. But, have the markets discounted a severe US recession? The answer is ‘no’.  A severe US recession, along with the ongoing slowdown in China and Europe, can severely impact global growth and corporate earnings, which is not yet reflected in global equity prices.

That said, our base case is a soft landing for the US economy. Even if the worst case scenario of a US recession materializes, it is likely to be mild rather than severe. US economic growth continues to be strong and unemployment is surprisingly low at 3.6 percent. Therefore, Jerome Powel in 2022 stands a good chance of doing what Allen Greenspan did in 1994: raising rates without tipping the economy into a recession.

A mild US recession is good for India

CPI inflation in India, though higher than RBI’s upper band, is lower than inflation in the DMs. More important, inflation is trending down, though mildly. CPI inflation has declined from 7.79 percent in April to 7.04 percent in May to 7.01 percent in June. This downward trend can sustain, given the recent sharp decline in commodity prices. But inflation will remain elevated till December 2022 and decline thereafter.

The decline in commodity prices from their recent peaks has been sharp: crude is down 30 percent; aluminium by 36 percent, copper by 21 percent and steel by 19 percent ( as on 16th July). Crude palm oil price is at 1-year low and soyabean oil is at 23-month low. If the US goes into a mild recession, crude prices will decline further. Citibank has projected Brent crude at around $ 60 if US tips into recession, say, by the end of 2022. Such a sharp crash in crude would be a blessing in disguise for India. Indian economy had bounced back smartly after every US recession.

Market leadership is changing

Indian economy is showing great resilience in the midst of the global economic headwinds. This bodes well for corporate earnings and stock markets. But investors should take note of the subtle changes happening in market leadership. If we take the last 6-month return, Nifty is down by 5.10 percent; Nifty IT is sharply down by 21.87percent and Nifty Bank is down by 2.22 percent. In contrast to this downtrend, Nifty FMCG is up by 15.46 percent and Nifty Auto is up by 9.28 percent during the last 6-month period (Data as on 21st July). These changes are significant.

 IT, which was the undisputed leader of the rally in 2020 and 2021 is struggling now on concerns of the probable US recession impacting tech demand. The metals rally has fizzled out following the sharp correction in metal prices. Financials, in spite of their good performance, had been impacted by the relentless FPI selling. New segments are gaining strength. Auto sector is showing good rebound and is poised to do well since the demand for CVs and passenger vehicles is robust and the chip shortage issue is easing. Commodity consumers like FMCG and consumer durables segment stand to benefit from decline in input prices. Capital goods segment is doing well assisted by the pick-up in capex. There are many segments in the broader market which are doing well, where the action is stock-specific. It is also important to note that the valuations of IT and financials are now attractive after the correction. These are straws in the wind which will enable investors to restructure their portfolios.

Is the relentless FII selling over?

FIIs have been selling relentlessly since October 2021. It is important to appreciate the fact that FII selling has not been due to any India-specific reason. They have been selling on valuation concerns in the last 3 months in 2021 and on rupee depreciation concerns in 2022. These two concerns were genuine. Now that dollar appears to have peaked – dollar index is down to 107.2 from the recent peak of above 109 – FIIs are unlikely to sell heavily unless the markets rally sharply. The 5-day FII buying streak for the weak ended 22nd July is an indication of a likely change in the investment strategy of FIIs.

The biggest unknown in the market continues to be the likely trend in the global economy. When the leading central banks are raising rates, growth slowdown is inevitable in 2022. But the likely trend in 2023 is foggy. The Fed raised its interest rate by another 0.75 percentage point on July 27th. ECB has joined other leading central banks with a 50 bp rate hike on 20th July. Markets will remain volatile so long as leading central banks are raising rates. Investors can utilise this volatility to buy high-quality growth stocks on dips.

The jury is still out on whether this is a bear market rally or the beginning of another bull market. Time alone can give us an answer. Meanwhile, investors should do what smart investors have always done: continue investing intelligently and systematically.

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